February 9, 2013

While I’m on the subject of commodity spreads and transformations, I’ll turn my attention to another spread story in the commodity news: cash premiums in aluminum. This is a matter of great interest to people in the aluminum business, but even though I highly doubt such people make up a big fraction of my readers, it’s worth some analysis here because the broader and politically charged topic of the “financialization” of commodities has come to the fore in this debate.

So we have a spread. Spreads price transformations. What is the transformation at issue here? Turning metal inside warehouses into metal outside of warehouses. So if the spread is wide, that tells us that there must be a bottleneck in getting Al out of warehouses. And indeed there is. It can take more than a year (!) to get some metal out of LME warehouses. Warehouse operators (including Goldman, JP Morgan, and Glencore) are the subject of bitter criticism from aluminum consumers (e.g,. Coca Cola) for what consumers claim are unnecessarily glacial load-out rates. File this under There is Nothing New Under the Sun. Warehousemen and consumers have fought over load-out rates forever in every commodity. (Look at a history of the warehouse wars in Chicago stretching back to the mid-19th century.)

As a result of the load-out bottleneck, large quantities of aluminum inventory that built up during the financial crisis and period of extended economic weakness in the US and Europe, are trapped in warehouses. The storage facilities have become the metallic equivalent of Roach Motels: aluminum checks in, but it can’t check out. Or maybe the metallic Hotel California: aluminum can check in, but it can never leave.

The fact that large quantities of metal are trapped in warehouses means that there are large quantities of metal that have to be carried-and financed, primarily in cash-and-carry trades hedged by forward sales. What other alternative is there? It ain’t going anywhere, so it has to be held and financed by somebody. Moreover, well-capitalized banks (Morgan, Goldman, etc.) can finance the inventory cheaper than anybody else. So just surely as day follows night, given the fundamentals in the market, and crucially the load-out bottleneck, the well-capitalized banks end up holding, financing, and hedging a big chunk of the inventory.

Here’s where the financialization meme comes in. Many people-including some who should know better-see the co-existence of financed inventory and premiums, and conclude that it is the participation of financial institutions that is causing the wide premiums. See! they exclaim. Look at how the participation of financial institutions in commodity markets is distorting things! Something must be done!

This is totally back-asswards, and confuses cause and effect. The underlying problem here is the load-out constraint. The cash premiums clearly signal that is the problem. Banks are not holding back metal to create profitable financing deals: time spreads adjust so that financing deals break even. The problem is that insufficient quantities of metal can get out of warehouses. That’s what inquiries should focus on. Is the rate too low? Why? Are warehousemen exercising market power by unduly constraining load-out? If so, why isn’t there sufficient competition between them? (It would also seem that this would have to be an ex post holdup problem: if those storing metal anticipated the exercise of market power via slow load-out, it would reduce their derived demand for storage, thereby reducing the amount of metal stored and the rate the warehouse could charge. This would tend to attenuate and perhaps eliminate the ability and incentive to exercise market power. An opportunistic response to an exceptional circumstance not anticipated when metal was put into store could be what is going on. That is, this could be a time inconsistency problem combined with an unprecedented shock.)

In other words, large financing deals are a symptom of the load-out bottleneck, and the overhang of metal in store resulting from the financial crisis. It is not the financing deals that are holding back metal. It is the load-out bottleneck that is holding back the metal, and driving the need to finance the metal.

One last note. One of the biggest complainers about the situation and the involvement of banks in the aluminum market is the living proof that Neanderthals still walk the earth: Oleg Deripaska. Yes, Putin’s favorite pen catcher. Word to the wise: Deripaska’s whines about the causes of the aluminum cash premiums should be heavily discounted, as should always be the case when a highly financially stressed individual loudly talks his book. Especially when the book talker has, shall we say, a rather testy relationship with banks.